On July 22nd and 23rd, we held our annual Fund Finance Mid-Year Market Update Panels, this year in Los Angeles and San Francisco (the “Market Updates”).1 Based on our experiences and the views expressed by the panelists at the Market Updates, capital call subscription credit facilities (each, a “Facility”) have continued their positive credit performance and growth momentum in the first half of 2014. Below we set forth our views of the current market trends and developments likely to be relevant for the remainder of 2014.

Credit Performance

2014 Year-to-Date Credit Performance

Mirroring all of 2013, Mayer Brown LLP has not been consulted on a Facility payment event of default or an institutional investor exclusion event in 1H 2014 and we are not aware of any existing Facilities under credit duress. All five of the bank panelists speaking at the Market Updates reported consistent credit performance across their portfolios so far this year.

Short-Term Credit Forecast

Fund Investment Performance. There is an abundance of data that forecasts continuing positive Facility credit performance on the macro level for the foreseeable future. Private equity funds of virtually all asset classes and vintages (each, a “Fund”) have achieved positive investment return performance in the recent past. The Cambridge Associates LLC US Private Equity Index® (the “C-A Index”) shows one-year and three-year returns as of December 31, 2013 of 20.6% and 14.9%, respectively, and Preqin reports promising current aggregate cumulative returns for Funds of virtually all vintages and geographies. This positive performance has continued into 2014, with Preqin reporting as one example a 6.3% average increase in net asset value (“NAV”) for real estate Funds in 1H 2014.2 While positive Fund investment performance enhances Facility repayment prospects in its own right, Fund limited partners (each, an “Investor”) with demonstrable NAV in a Fund are highly incentivized to fund future capital calls (“Capital Calls”) and avoid the severe default remedies typical in a Fund partnership agreement (each, a “Partnership Agreement”). Setting aside the well-established, enforceable contractual obligations of the Investors, it is difficult to foresee widespread Investor funding defaults in the near term when the vast majority of existing Funds have generated positive returns.3

Harvest Events and Investor Distributions. Additionally, there is generally positive liquidity data at virtually every level of the Fund structure relevant for Facility lenders (“Lenders”). Private equity-backed investment exits in 2014 have continued and built upon the robust harvest activity in 2013, with 394 transactions valued at $137 billion in Q2 2014 alone.4 Exit events of course lead to Investor distributions, and distributions are at record levels. In 2013, Fund distributions to Investors greatly exceeded capital contributions called and funded, with Funds in the C-A Index calling $56.3 billion, while distributing $134.6 billion (the largest yearly amount since the C-A Index’s inception). On a global basis, $568 billion was distributed back to Investors in 2013 (up 49% from 2012).5 Investors receiving significant distributions forecasts well for their ability to fund future Capital Calls.

Secondary Funds. The fundraising success of secondary Funds, Facility borrowers in their own right, has created an unprecedented volume of dry powder available to offer exit opportunities to any Investor that experiences liquidity challenges and needs to exit a Fund position. In fact, the single-largest Fund closed in Q2 2014, and the single largest secondary Fund to close in history was the Ardian Secondary Fund VI, closing on $9 billion in April. There has reportedly been $15 billion raised by secondary Funds in 1H 2014 and there are multiple premier Sponsors in the midst of fundraising with significant interim traction. This significant growth in secondary Fund dry powder creates a readily available market for any Investor wishing to transfer, whether for diversification purposes or because of financial distress, and the current secondary market is very active. The first half of 2014 saw more than $16 billion of secondary transactions (an annualized pace that would exceed 2013 by over 10%) and it has been reported that the Montana Board of Investments received more than 40 offers for eight Fund positions that it recently put out for bid.6 If the Facility market performed extremely well during the financial crisis when the secondary Fund market was a fraction of what it is today, today’s secondary Funds market with some $50 billion in dry powder certainly provides Lenders a far greater buffer to any initial collateral deterioration.

Long-Term Credit Forecast Concerns

Despite the nearly uniform positive trending in the data above supporting Facility credit performance, none of it goes to the heart of the fundamental credit underwriting premise of a Facility. That is, that the Investors’ uncalled capital commitments are unconditionally due, payable and enforceable when called, regardless of Fund investment performance, NAV, receipt of distributions, market liquidity or Investor transfers. And from this vantage point, the 2014 year-to-date trending has been far less beneficial for Lenders. We have for some time been noting that Facility structures have been drifting in favor of the Funds and that Lenders have become increasingly comfortable going incrementally down the risk continuum, at least for their favored Fund sponsors (“Sponsors”). In fact, at the end of 2013, we gave the view that much of the trending (as an example, the including of certain historically excluded Investors in borrowing bases at limited concentrations) seemed perfectly rational and completely supportable by the available Investor funding data. But as 2014 has progressed and the downward trending has continued, we are seeing the emergence of structural issues in prospective Facilities that we believe further conflict with Lenders’ general expectations as to the appropriate allocation of risk between the Lenders, Funds and Investors. While the Facility market is far from uniform and every particular Facility needs to be evaluated in its own context, there are a number of emerging credit concerns we think Lenders should rightfully put heavy emphasis on. Examples include Partnership Agreements that fail to appropriately contemplate or authorize a Facility, overcall limitations structured so tightly that the degree of overcolleralization buffering Investor defaults is insufficiently adequate to cover the Facility obligations in a period of distress, lack of express Investor obligations to fund without setoff, counterclaim or defense, and Fund vehicles being formed in non-US partnership structures that require the Fund to issue some form of equity shares or certificates each time a Capital Call is funded. And there are others. Our view has been, and remains, that the most likely way a Lender will suffer losses in this space is not via widespread Investor credit deterioration, but rather via a Sponsor or Fund failing to meet its contractual obligations to Investors, ultimately resulting in a dispute and an Investor enforcement scenario. Thus, Lenders should thoughtfully contemplate documentation and structural risks that undermine their expected enforcement rights. If this downward trending on the risk continuum continues at its current pace, we ultimately see an inflection point where particular Lenders determine that certain proposed structures simply drift too far from the fundamental tenets of a Facility and no longer meet the investment grade credit profile expected in a Facility.

Facility Market Expansion

Fundraising

Fund formation in the first half of 2014 has remained positive and generally consistent with levels seen in 2013. 417 Funds had their final closing, raising $236 billion in capital commitments in 1H 2014. The “flight to quality” trend has continued, with fewer Funds being formed but raising more capital, with the average Fund size in Q2 2014 being the largest to date.7 We continue to think this trend towards consolidation slightly favors incumbent and larger Lenders at the expense of new entrants and smaller institutions. Experienced Sponsors are more likely to have existing relationships with incumbent Lenders in multiple contexts and larger Funds need larger Lender commitment sizes in Facilities. We note, however, that several smaller Lenders have greatly increased their maximum hold positions and have created syndicate partnerships to effectively compete.

Deal Volume and Pipeline

Facility deal volume remains robust and likely above 2013’s pace, although we hesitate to confirm the double-digit growth we forecasted in January based on the available anecdotal evidence alone. The pipeline of both large syndicated transactions and bilateral deals forecasts well for the remainder of the year. We expect 2014 deal volume to ultimately finish ahead of 2013, albeit perhaps by only single digits.

Growth Prospects

The Facility market, in our view, still projects substantial opportunity for future growth. With global dry powder now at an all-time high of $1.16 trillion as of the end of Q2 2014, up a full 8% from the end of 2013, there is simply a greater and increasing pool of collateral available to support Facilities.8 And if you take a ratio of Facility size to Fund uncalled capital across a large portfolio of Facilities (admittedly not a statistic clustered close to the mean) and determine an average percentage, say 30%, you could project out a potential Facility market size of well over $300 billion. As most market participants estimate the current Facility market to be less than $200 billion, it does appear that plenty of existing Funds have yet to benefit from Facilities. When you combine this room for further penetration into Funds new to Facilities with the greater volume of Funds presently fundraising (estimated currently around 2,000), the increasing use of returned capital mechanics to refresh dry powder and the greater use of Facilities throughout the entire Fund life cycle, it seems evident that the opportunity for outpaced growth remains.9

Facility Market Trends

There are a number of interesting trends in the Facility Market itself that are impacting both transaction structures and terms. We highlight below a few that are most impactful.

Extensive Refinancing Activity

Many Facilities of 2011 or so vintage have been coming up for renewal and the vast majority have been extending instead of terminating. Lenders are increasingly comfortable extending Facilities beyond Fund investment periods (subject to appropriately supportive language in Partnership Agreements) and Funds appear to be valuing the liquidity and other utility of a Facility well into their harvest periods. Virtually all Facilities coming up for renewal have been pricing flat to down, further encouraging their extension. We expect the volume of amend and extend activity to increase slightly towards year-end, mirroring an uptick we experienced in 2H 2011.

Transaction Structures

Structural Evolution. The evolution of Fund structures continues to complicate Facility structures, as the incorporation of multiple Fund vehicles, in an effort to optimize investment structure for Investors, is continuing and perhaps accelerating. Separately managed accounts, co-investment vehicles, joint ventures and parallel funds of one are all increasingly common, each of which stress the traditional commingled Fund collateral package for a Facility. As the various vehicles often have challenges being jointly and severally liable for Facility obligations, Lenders are increasingly finding themselves with Facility requests involving single-Investor exposures. Interestingly, in certain instances, these singleInvestor exposure structures are leading back to the delivery of Investor acknowledgment letters (which have been in certain cases trending out of the commingled Fund market), as Lenders seek credit enhancements to offset the lack of multiple Investor overcollateralization.

Umbrella Facilities. We are seeing increased appetite for umbrella Facilities (multiple Facilities for unrelated Funds advised by the same Sponsor but documented on the same terms in a single set of loan documents). In fact, Mayer Brown LLP has closed more umbrella Facilities in 1H 2014 than in all of 2013.

Hedging Mechanics. Embedding hedging and swap collateralization mechanics into Facilities has also accelerated in 1H 2014. While extending Facility collateral to cover collateralization requirements under ISDAs entered between the Fund and the Lender has existed in the bilateral Facility market for some time, including clear structural borrowing base allocation, tracking and measurement mechanics in syndicated Facilities is relatively new.

Regulatory Impact

The regulatory landscape continues to occupy a substantial amount of Lender and Sponsor time. Analyzing Facilities for compliance with the final Volcker Rule, for appropriate risk weighting under Basel III and other regulatory capital regimes and the appropriate outflow analysis under the minimum liquidity coverage ratio promulgated by the US regulatory agencies all require thoughtful care in application to Facilities, especially in light of the speed of Facility structural evolution. We expect the regulatory environment will be increasingly relevant throughout 2014 and that Lenders may ultimately need to structure around, or price, for their increasing regulatory requirements, particularly around Facility unfunded revolving commitments.10

Legal Developments

Cayman Islands Legal Developments

Two new statutory enactments have occurred in the Cayman Islands in 1H 2014, both of which are in small part helpful to Lenders. The first, the Contracts (Rights of Third Parties) Law, 2014, was enacted on May 21, 2014. Although not explicit as to Facilities, the new law allows third parties not party to a contract (such as a Partnership Agreement) to rely on and enforce provisions that are intended by the contracting parties to benefit the third parties, even though the third parties are not signatories. This brings Cayman Islands’ third-party beneficiary law closer in line with other jurisdictions and can ultimately accrue to the reliance and enforcement benefit of Lenders if Partnership Agreements are expressly drafted to do so. The second key change is the enactment of the revised Exempted Limited Partnership Law, 2014, which took effect on July 2, 2014 and is a comprehensive revision of previous Cayman Islands exempted limited partnership law. While few of the changes are relevant for Facilities, the new law does expressly confirm that any right to make Capital Calls and to receive the proceeds thereof vested in a general partner or the Fund shall be held by the general partner as an asset of the Fund, thus providing greater certainty of a Fund’s right to grant security in the right to issue and enforce Capital Calls.11

Case Law Development: Wibbert v. New Silk

A case of interest to Lenders, Wibbert Investment Co. v. New Silk Route PE Asia Fund LP, et al., is pending in the New York state courts. While no mention of a Facility is evident in the pleadings, the case is illustrative of the type of fact pattern and dispute that could potentially find a Lender in an enforcement scenario. In this case, the Investor, Wibbert Investment Co. (“Wibbert”), alleges, among other things, that the Fund failed to disclose the occurrence of a key person event after a principal of the Sponsor was charged and convicted of insider trading and that the Fund’s general partner committed gross negligence and/or willful malfeasance. The Fund fully contests the claims and the facts are in dispute. Wibbert has declined to fund a Capital Call and alleges that the Fund has threatened to implement default remedies as a result. On June 17, 2014, at Wibbert’s request, the New York Supreme Court, Appellate Division, granted a preliminary injunction in favor of Wibbert barring the Fund from declaring Wibbert in default and from exercising default remedies while the case proceeds. The ruling is currently on appeal. While the facts of this case are highly unique and have involved extensive publicity in connection with the trials and convictions of certain of the principals, the case does stand as evidence of why Lenders may want to consider the importance of a contractual obligation on Investors to fund Capital Calls to Lenders without setoff, counterclaim or defense. The case merits further attention and monitoring as it proceeds.12

Case Law Development: TL Ventures, Inc.

In June 2014, the US Securities and Exchange Commission (the “SEC”) brought a pay-to-play case against a Sponsor pursuant to Sections 203(e) and 203(k) of the Investment Advisers Act of 1940 (the “Advisers Act”), to our knowledge the first such case brought by the SEC. The SEC alleged that an associate of TL Ventures, Inc. made a $2,500 campaign contribution to the Mayor of Philadelphia and a $2,000 campaign contribution to the Governor of Pennsylvania at a time when the Pennsylvania State Employees’ Retirement System was an Investor in Funds sponsored by TL Ventures, Inc. Both the Mayor and the Governor have vested authority to appoint certain people with influence as to investment selection. The SEC alleged that this action violated Section 206(4) and Rule 206(4)-5 of the Advisers Act, noting that it need not allege or demonstrate a showing of quid pro quo or actual intent to influence an elected official by the Sponsor. The Sponsor, without admitting or denying the relevant subject matter, consented to an order with the SEC to resolve the matter. As Lenders are increasingly reviewing side letters between governmental Investors and Funds that contain withdrawal and/or cease-funding rights if prohibited political contributions are made or improperly disclosed, Lenders must bear in mind that such a circumstance may not be purely hypothetical and that even the most innocent and well-intentioned political contributions may trigger the withdrawal rights.13

LSTA Model Credit Agreement Provisions

On June 25, 2014, the Loan Syndications and Trading Association® published an exposure draft of its Model Credit Agreement Provisions. The proposed revisions include a host of technical revisions, but the two most relevant revisions relating to Facilities include an extensive set of mechanics governing facility extensions and changes to the lender assignment and participation provisions, including certain prohibitions of assignments or participations by lenders to competitors of the borrower or institutions the borrower has requested in advance be disqualified for assignments or participations. August 8, 2014 is the current target date the LSTA plans to publish the revisions. A copy of the exposure draft is available to LSTA members on the LSTA’s website at http://www.lsta. org/legal-and-documentation/primary-market. 14

Conclusion

We project a robust Facility market to continue in 2H 2014 building on the growth and positive momentum to date, but with competitive, structural and underwriting challenges at the margins. We expect the number of Facilities consummated will continue to grow at an outpaced but measured rate, reflective of the time-consuming nature of educating new Sponsors of the utility and benefits of a Facility. We continue to anticipate excellent credit performance throughout the remainder of 2014, but recommend caution to Lenders as certain emerging Facility structures reallocate the traditional Facility risk allocations among Lenders, Funds and Investors and stress some of the most fundamental tenets of a Facility.

Endnotes

1 Mayer Brown LLP would like to thank the panelists at the Market Updates. In Los Angeles: Kristin Rylko, Partner, Mayer Brown LLP (Moderator), John Gilb, Senior Managing Director, CBRE Global Investors, Ann Richardson Knox, Partner, Mayer Brown LLP, Nick Mitra, Executive Director, Natixis, Matt Posthuma, Partner, Mayer Brown LLP, Tom Soto, Managing Director, TCW, Emily Stephens, Managing Director, Oaktree Capital Management, LLP, David Wasserman, Executive Director, Sumitomo Mitsui Banking Corporation, and Tom Wuchenich, Partner, Simpson Thacher & Bartlett LLP. In San Francisco: Zac Barnett, Partner, Mayer Brown LLP (Moderator), Scott Case, Global Head of Private Equity Services, Silicon Valley Bank, Kevin Dunwoodie, Principal, Pantheon, Jeff Johnston, Managing Director and Head of Subscription Finance Origination, Wells Fargo Bank, N.A., Mary Touchstone, Counsel, Simpson Thacher & Bartlett LLP, Matt McCormick, Vice President, Stockbridge, Wes Misson, Attorney, Mayer Brown LLP, and Robert Wood, Director, Bank of America, N.A.

2 See US PE/VC Benchmark Commentary, Quarter and Year Ending December 31, 2013 (the “C-A Benchmark”), Table 1, page 2, Cambridge Associates, July 2014, available at http://40926u2govf9kuqen1ndit018su. wpengine.netdna-cdn.com/wp-content/uploads/2014/07/ US-PE-VC-Benchmark-Commentary-4Q13.pdf; Preqin Quarterly Update: Private Equity, Q2 2014 (“Preqin PE Q2”), Figure 3, page 8; Preqin Quarterly Update: Real Estate, Q2 2014, page 7.

3 For an in-depth review of the enforceability of Investor capital commitments, please see Mayer Brown’s Legal Update, “Enforceability of Capital Commitments in a Subscription Credit Facility,” on page 1.

4 Preqin PE Q2, page 8.

5 See C-A Benchmark, Figure 1, page 6; Preqin PE Q2, page 2.

6 See, Secondaries Investor, news compendium, page 3; available for download at http://www.secondariesinvestor.com/newscompendium/; Secondary Market Trends & Outlook, Cogent Partners, July 2014, p. 1.

7 See Preqin PE Q2, Figure 1, page 5.

8 Id., page 2.

9 Id., page 3.

10 For an in-depth review of applying the Volcker Rule to Facilities, please see Mayer Brown’s Legal Update, “Subscription Credit Facilities and the Volcker Rule”; on page 103 for an in-depth review of applying the Liquidity Coverage Ratio to Facilities, please see Mayer Brown’s Legal Update, “Capital Commitment Subscription Facilities and the Proposed Liquidity Coverage Ratio,” on page 75.

11 Mayer Brown LLP is not licensed to and does not give advice as to matters of Cayman Islands law. Any questions on the laws of the Cayman Islands should be directed to attorneys therein licensed. Appleby Legal Updates on these legal developments can be found at http://www.applebyglobal.com/publication-pdfversions/e-alerts/ealert—cayman – to- welcome-third -party-rights-rules—(april-2014)-sraftopoulos–lrichter. pdf; http://www.applebyglobal.com/publication-pdfversions/e-alerts/2014—07—update-changes-to-thecayman-islands-exempted-limited-partnership-law— bh-sr-jb-ig-bw.pdf; and http://sites.appleby.vuturevx. com/18/2890/uploads/2014—04—changes-to-thecayman-islands-exempted-limited-partnership-law- (bhunter–sraftopoulos–igobin–jblack).pdf.

12 The case is Wibbert Investment Co. v. New Silk Route PE Asia Fund LP, et al., case number 650437/2013, in the Supreme Court of the State of New York, County of New York.

13 The case is In the Matter of TL Ventures Inc., case number 3-15940, before the SEC.

14 Special thanks to Mayer Brown LLP summer associates, Kim Perez, 3L, University of North Carolina School of Law, and Daniel Waxman, 3L, Wake Forest University School of Law, for their research contributions to this article

Infrastructure funds are private equity vehicles that invest in a wide range of assets—including assets that could be described as transportation, energy and utility, communications, and “social” infrastructure, and investments that may be specific to a particular asset or in a company that develops such assets or is otherwise involved in their operation. Like other private equity funds, they have limited lifespans, typically five to ten years. They often attract capital commitments from investors with appetites for relatively stable, long-term cash flows, many of which have liabilities stretching over several decades. General partners of infrastructure funds are often able to leverage those commitments during the investment period.

In recent years, institutional investors have felt increased pressure to search for higher returns and diversify from traditional asset categories such as public equities and fixed income instruments. After slumping in 2011, fund-raising by infrastructure funds improved significantly in 2012 and 2013, with capital raised in the first three quarters totaling $19 billion.1 Despite an increase in the average fundraising lifecycle,2 not only did capital commitments to infrastructure funds continue to grow, investors indicated that they were looking to expand their infrastructure allocation.

Pension funds are notably increasing their exposure. The Alaska Retirement Board committed $300 million to two infrastructure funds—$200 million to IFM Global Infrastructure Fund and $100 million to J.P. Morgan Infrastructure Investments Fund—and has a long-term infrastructure target allocation of 12.5% within the real assets portfolio, or 2.125% of total plan assets.3 The Kentucky Teachers’ Retirement System committed $100 million to IFM’s Global Infrastructure Fund,4 and the Missouri Education Pension Trust committed $75 million to Alterna Core Capital Assets Fund II.5 The $420 million Chicago Park Employees’ Pension Fund entered the infrastructure space by committing $10 million each to infrastructure funds managed by Ullico Investment Co. and Industry Funds Management.6 There is, however, considerable room for growth among pension funds. According to a new report from the Organization for Economic Co-Operation and Development (OECD), unlisted equity and debt infrastructure investments for the 69 survey respondents amounted to only 0.9% of total respondent assets.7

This growth is being driven by renewed demand for stable, long-term returns in a lower-yield environment, and a variety of “infrastructure” asset classes are filling that demand. With respect to power production, renewables have been popular, and the largest independent power producers were able to take operating assets into the public markets in ways that provide attractive exit opportunities. In 2013, Pattern Renewable Energy and NRG publicly listed “yieldcos,” which aggregate the cash equity return from utility-scale power projects that have debt and tax equity financing. Several other renewable energy developers are in the process of evaluating if such a structure would benefit them.

In the transportation space, several states moved forward with initiatives to facilitate private investment in toll roads and other similar assets, and successful project completions in recent years leads some to believe that future formations of such partnerships are likely. Virginia is moving ahead with a series of PPP toll road procurements following the successful completion of its I-495 Express Lanes project, which at $2 billion was delivered on time and on budget. In November 2013, the New Jersey Turnpike Authority put out a request for proposals seeking bids for toll collection services, including management of the electronic tolling system and the toll collectors.8 MAT Concessionaire, LLC (MAT) received a 35-year concession agreement, which includes 55 months for design and construction, for the Port of Miami tunnel project, one of the first to make use of availability payments. Design and construction costs are currently at $663 million. MAT will be paid $156 million in milestone payments during construction and a $350 million payment upon final acceptance of the construction works. The majority of MAT’s equity is being provided by a Meridiam infrastructure fund.

A number of infrastructure funds are also seeking to satisfy the need for debt as an alternative to traditional bank and bond financing at the project level.9 Of the 1,700+ active investors in the infrastructure asset class tracked by Preqin, as of February 2013, 285 were actively considering debt investment opportunities. Darby Overseas Investments has raised three debt funds totaling $442 million, and Allianz Global Investors is currently working on a £1 billion UK-focused debt fund that will provide debt financing to a wide range of both economic and social infrastructure projects.10

While investor appetite for the various infrastructure asset classes continues to grow, so have fundraising challenges for a variety of reasons, first among them the record number and aggregate target of all funds in market.11 (A consequence of the crowded fundraising environment is the increasing use of placement agents to assist in the fundraising process, and with reason—over the past two years, infrastructure funds that have used placement agents have been more likely to meet or exceed fundraising targets and to reach financial close.12) Investors indicate that the most attractive managers are those with cohesive and concise plans, a focus on high cash yield and defensive and predictable investments, a healthy deal pipeline, and, most importantly, strong past performance.13 (Globally, the top ten infrastructure fund managers account for 45% of capital raised by infrastructure funds in the last ten years, and the largest firm, Macquarie Infrastructure and Real Assets, raised over six times the amount raised by the tenth largest firm, LS Power Group, but that percentage has dropped in recent years as more firms have entered the asset class.14) Current portfolios of infrastructure fund limited partners demonstrate a preference for regional-focused funds, but there is increasing preference for geographic diversification as well.15

Further increasing pressure on fund managers is the trend for large, sophisticated institutional investors to bypass infrastructure funds entirely and make direct investments.16 While the motivations vary—to avoid paying fund management fees and lower carrying costs, increase control over asset disposition decisions, deploy additional capital, and avoid the disposition of assets that could continue to generate steady returns—making direct investments requires significant investments in manpower and the development of a variety of skills. In addition to performing upfront technical, legal, regulatory, and financial diligence, such investors need project management and asset divestiture expertise. While only the largest and most sophisticated investors are able to execute such a direct investment strategy effectively, direct investments and co-investments are increasingly utilized,17 and investors are conditioning fund commitments on the ability to retain control of key investment decisions, including investment horizons.18

In assessing infrastructure investments, investors and fund managers face a variety of concerns that are less relevant in other asset classes. In particular, the stability of the applicable regulatory regime, and the possibility of changes in law that may materially impact investments, are often critically important inquiries. For investments in emerging markets, the risks of adverse action by local governments come to mind fairly readily, but such actions have major impacts in developed markets as well. The renewable sector provides particularly clear examples. Spanish solar tariffs were reduced retroactively, Germany’s were cut prospectively, and elections in Ontario, Canada, were in large part a referendum on the province’s renewable energy programs. In the United States, key federal tax incentives have repeatedly been renewed and extended only on short-term bases, and there is concern about the deferral of state renewable mandates and the implementation of reliability and market-efficiency mandates by quasi-governmental grid operators. Other infrastructure asset classes present similar concerns. The privatization of government-owned assets generally requires express legislative or municipal authorization, which can be heavily conditioned, and is often subject to intense public scrutiny that may lead to renegotiation, as occurred last summer with respect to the City of Chicago’s parking concession.

Infrastructure funds face uncertainties less relevant to funds than investments in other asset classes—for example, the significant risk of statutory and regulatory change affecting existing and target assets, the prevalence of pension and sovereign investors that have strong motivations to bypass the fund structure in favor of direct and co-investments, and the range of expertise needed to diligence and manage such a broad category of assets. Their recent growth, and the momentum of that growth, suggests that that the industry is able to turn such challenges into opportunities. We expect that it will continue to do so, and that the financing structures the industry utilizes will continue to evolve as well.

Endnotes

1 The Preqin Quarterly Update: Infrastructure (Preqin, New York, N.Y.), Oct. 2013.

2 Infrastructure Fundraising: Time on the Road, Infrastructure Spotlight (Preqin, New York, N.Y.), Oct. 2013, at 2.

3 Kevin Olsen, Alaska Retirement Board Earmarks $300 Million for 2 Infrastructure Funds, Pensions & Investments (Sept. 25, 2013, 2:14 PM).

4 Infrastructure Investor Research & Analytics: Infrastructure Investor Half Year Fundraising Review 2013, 1, 7 (Ethan Koh Ke Ling ed., 2013).

5 Rob Kozlowski, Missouri Education Pension Trust Commits to Infrastructure, Real Estate, Pensions & Investments (Oct. 29, 2013, 3:17 PM), http://www. pionline.com/article/20131029/ONLINE/131029859/ missouri-education-pension-trust-commits-to-infrastructure-real-estate.

6 Kevin Olsen, Chicago Park Employees’ Pension Fund Takes First Step Into Infrastructure, Pensions & Investments (July 31, 2013, 3:04 PM).

7 Kevin Olsen, OECD: World’s Largest Pension Funds Slow to Take on Infrastructure Investing, Pensions & Investments (Oct. 18, 2013 6:43PM), http://www. pionline.com/article/20131018/ONLINE/131019864/ oecd-worlds-largest-pension-funds-slow-to-take-oninfrastructure-investing.

8 Mike Frassinelli, Toll Collector Jobs on N.J. Turnpike, Parkway Likely to be Privatized, NJ.com (Nov. 19, 2013 6:17PM) http://www.nj.com/news/index. ssf/2013/11/toll_collector_jobs_on_nj_turnpike_parkway_likely_to_be_privatized.html.

9 BlackRock Infrastructure Debt Team, BlackRock: Bridging the Gap—The Rise of Infra Funds in Privately Financed Infrastructure, CFI (Oct. 29, 2013), available at http://cfi.co/europe/2013/10/ blackrock-bridging-the-gap-the-rise-of-infra-funds-inprivately-financed-infrastructure

10 Paul Bishop, A Recipe for Infrastructure Fundraising Success in the Post-Crisis Marketplace—Placement Agents, Preqin Blog (Mar. 20, 2012), https://www. preqin.com/blog/101/4953/ infrastructure-placement-agent.

11 Q3 2013, The Preqin Quarterly Update: Infrastructure (Preqin, New York, N.Y.), Oct. 2013, at 2.

12 Infrastructure Fundraising: Future Prospects, INFRASTRUCTURE SPOTLIGHT (Preqin, New York, N.Y.), Nov. 2012, at 2, 4.

13 Infrastructure Fundraising: Future Prospects, INFRASTRUCTURE SPOTLIGHT (Preqin, New York, N.Y.), Nov. 2012, at 2, 4; Arleen Jacobius, Heydays Past, Infrastructure Firms Feel Heat, PENSIONS & INVESTMENTS, Aug. 5, 2013, available at http:// www.pionline.com/article/20130805/ PRINT/308059979/ heydays-past-infrastructure-firms-feel-heat.

14 Press Release, Preqin, The Top 10 Infrastructure Fund Managers Account for 45% of Capital Raised by Infrastructure Funds in the Last 10 Years (July 17, 2013).

15 Infrastructure Investor Research & Analytics: Infrastructure Investor Half Year Fundraising Review 2013, 1, 7 (Ethan Koh Ke Ling ed., 2013).

16 Tim Burroughs, Infrastructure Funding: A Beast with Two Heads, ASIAN VENTURE CAPITAL J., Sept. 25, 2013, available at http://www.avcj.com/avcj/analysis/2296692/asian-infrastructure-a-beast-with-two-heads.

17 Annual Survey of Large Pension Funds and Public Pension Reserve Funds, 14 (OECD, Oct. 2013).

18 Infrastructure Investor Research & Analytics: Infrastructure Investor Half Year Fundraising Review 2013, 11 (Ethan Koh Ke Ling ed., 2013).

Due to previous challenges in the United States fundraising market for sponsors of real estate, private equity and other investment funds (each a “Fund”), many Fund sponsors have sought to expand their sources of capital to include investors domiciled outside of the United States (“Foreign Investors”). As such, Fund sponsors are increasingly requesting that the unfunded capital commitments of these Foreign Investors be included in the borrowing availability (the “Borrowing Base”) under the Fund’s subscription credit facility (a “Subscription Facility”).

While traditionally Funds have not chosen their lenders solely based upon whether such lender would include Foreign Investors’ capital commitments in the Borrowing Base, it is becoming a more critical factor. Consequently, understanding and addressing collateral enforceability issues related to Foreign Investors has become increasingly important for lenders. Below we set out our views on common concerns regarding collateral enforceability and some possible solutions for minimizing such risk.

Subscription Credit Facilities and Foreign Investors

A Subscription Facility, also frequently referred to as a capital call facility, is a loan made by a bank or other credit institution (a “Lender”) to a Fund. The defining characteristic of such Subscription Facility is the collateral package, which is comprised not of the underlying investment assets of the Fund, but instead by the unfunded capital commitments (“Capital Commitments”) of the limited partners of the Fund (the “Investors”) to make capital contributions (“Capital Contributions”) when called from time to time by the Fund’s general partner (the “General Partner”). The loan documents for the Subscription Facility contain provisions securing the rights of the Lender, including a pledge of (a) the unfunded Capital Commitments of the Investors, (b) the right of the General Partner to make a call (each, a “Capital Call”) upon the Capital Commitments of the Investors after an event of default accompanied by the right to enforce the payment thereof, and (c) the account into which the Investors fund Capital Contributions in response to a Capital Call. Such rights of the Fund and its General Partner are governed by the Fund’s constituent documents, including its limited partnership agreement or operating agreement (collectively, the “Constituent Documents”).

Lenders have become comfortable with this collateral package because of (i) their ability to select high-credit quality Investors whose Capital Commitments comprise the Borrowing Base, and (ii) in the event that an Investor fails to fund its Capital Commitments, ability to enforce payment of its Capital Contributions in and under the laws of the United States. However, as the momentum toward including Foreign Investors in the Borrowing Base increases, Lenders are facing new challenges, including (i) the ability to determine the credit quality of Foreign Investors and (ii) the ability to enforce the payment of Capital Contributions from these Foreign Investors.

Key Issues

The three primary collateral enforceability issues that arise in connection with Foreign Investors include (i) as with all Investors, obtaining financial and other information during the due diligence process necessary to properly assess such Foreign Investor’s creditworthiness; (ii) obtaining jurisdiction in the courts of the United States over such Foreign Investor; and (iii) enforcing judgments issued by a court of the United States against such Foreign Investor.

Due Diligence

The Subscription Facility due diligence process typically includes obtaining and reviewing (i) the Constituent Documents of the Fund; (ii) the form subscription agreements (“Subscription Agreements”) executed by each Investor detailing, among other things, such Investor’s willingness to be bound by the terms and conditions of the Constituent Documents and disclosing, among other things, certain information of such Investor; and (iii) other side agreements (“Side Letters” and, together with the Subscription Agreements, the “Subscription Documents”) detailing alterations or exceptions, if any, to the Fund’s partnership agreement and/or the form of Subscription Agreement.

For Investors domiciled in the United States (“US Investors”), Lenders have typically included in the Borrowing Base investment-grade, noninvestment grade and non-rated institutional Investors. Assessment of the credit quality of such Investors has been relatively uncomplicated. Conversely, with regard to Foreign Investors, Lenders have been reluctant to assess their credit quality, often citing lack of financial information, which Foreign Investors are reluctant to provide for confidentiality reasons.

Nevertheless, Fund sponsors are becoming more aware of the need to obtain financial information from their Foreign Investors and are raising the matter earlier in the solicitation process. We anticipate that acquiring financial information from Foreign Investors whom the Fund would like included in the Borrowing Base will become a more customary part of the overall diligence process. However, many Foreign Investors have and are continuing to push back on requests for non-public information. It is not uncommon for a Foreign Investor to negotiate such a provision in its Side Letter with the caveat that it will cooperate with reasonable information requests from the Fund sponsor if necessary in connection with obtaining a Subscription Facility. Lenders will almost certainly require financial information from the Foreign Investor (or its parent entity) before giving the Fund full Borrowing Base credit for such Investor (credit that is typically at a 90% advance rate). Where the Foreign Investor is a subsidiary or special purpose vehicle owned by a parent entity with substantial credit quality, a guarantee or comfort letter providing direct credit linkage to the parent will often be required by Lenders before giving full Borrowing Base credit to the subsidiary or special purpose vehicle. Lenders are more often than not gaining comfort regarding credit quality from most Foreign Investors by obtaining financial and/or other information regarding such Foreign Investors from publicly available sources. We have also seen, and expect to see more, Lenders cooperating with their foreign affiliates to obtain additional information. Lenders relying on such information are often giving creditworthy Foreign Investors some Borrowing Base credit (at times at a 60-65% advance rate), which are often subject to tight concentration limits (both individually and as a class of Foreign Investors) and sometimes even skin-in-the-game tests aimed to limit the Lenders’ risk and overall exposure to this class of Investor. We expect to see the treatment of Foreign Investors develop over the coming years as the information becomes more transparent and these Investors become more critical to a Fund’s Borrowing Base.

Jurisdictional Issues

Foreign Investors can take the form of either individuals or entities, including governmental pension plans, state endowment funds, sovereign wealth funds and other instrumentalities of foreign governments (“Governmental Investors”). Such Governmental Investors are becoming more prevalent and are often some of the largest Investors in the Investor pool. For Lenders, the common concern with including such Investors in the Borrowing Base has been whether certain sovereign immunity rights, rooted in the common law concept that “the King can do no wrong,” could provide a defense against enforcement of such Investor’s obligation to make Capital Contributions after an event of default. Although sovereign immunity in its purist form could shield a governmental entity from all liability, Governmental Investors must be evaluated on a case-by-case basis to ascertain if any sovereign rights apply and, if so, whether such Investor has effectively waived its immunity.1

With regard to Foreign Investors generally, some Lenders have been reluctant to include such Investors due to concern with litigating and enforcing judgments in a United States court. A United States court’s ability to hear a case involving allegations against a foreign person or entity is governed by the laws of the applicable state and the Constitution. The laws of most, if not all, states provide that parties to a contract may select their governing law and venue for litigating disputes arising under such contract. For this reason, most, if not all, Subscription Documents and Constituent Documents include these provisions. Most often, either New York or Delaware is selected as the governing law and venue under these documents. Furthermore, most, if not all, Constituent Documents include provisions that would allow the General Partner (or Lender in the case of a default and failure of such Foreign Investor to fund its Capital Contribution) to liquidate the applicable Foreign Investor’s partnership interest or offset damages against distributions that would otherwise be payable to the Foreign Investor.

Lenders can additionally gain comfort by obtaining Investor consent letters, also commonly referred to as Investor letters or Investor acknowledgments (“Investor Letters”), wherein such Foreign Investor would confirm its unconditional obligation to fund its Capital Contribution, in accordance with the Subscription Documents and Constituent Documents. These letters could also address forum, venue and sovereign immunity provisions directly in favor of the Lenders. To the extent that forum and venue selection provisions are included in the Subscription Documents, Constituent Documents or Side Letters, the Lender can seek to enforce such provisions against a defaulting Foreign Investor, as assignee of the General Partner’s rights, under the collateral documents of the Subscription Facility. Such Lender could file a lawsuit or arbitration claim directly against such Foreign Investor in the applicable United States court or tribunal. While service of process on such Foreign Investor is always a concern when filing such a lawsuit or arbitration claim, Lenders could gain comfort by requesting in an Investor Letter (i) the designation of a United States entity to accept service of process and/or (ii) the express waiver of any objection as to adequacy of such service of process, so long as it has been effected. Similarly, as Fund sponsors become more aware, it is likely that such Fund sponsors will include comparable provision in Subscription Documents and Side Letters. Alternatively, the inclusion of arbitral provisions in Subscription Documents, Constituent Documents or Side Letters would avoid recognition and enforcement issues in most instances and would mitigate sovereign immunity claims in the case of most Governmental Investors. Immunity concerns (except to the extent otherwise covered in the Foreign Investor’s Subscription Documents, Side Letters or Investor Letters) could additionally be overcome via the Foreign Sovereign Immunities Act of 1976 and the exceptions included within Sections 1605-1607 thereof, including an exception for commercial activity that has a nexus to the United States.

Enforcement of Judgments

If a judgment is obtained against a Foreign Investor in a United States court, it may be difficult for the Lender to enforce such judgment against such Investor in the United States, unless such Foreign Investor has assets in the United States that are not otherwise subject to immunity. Therefore, the concern for many Lenders is whether such judgment could be enforced against such Foreign Investor in its country of domicile. While there is currently no treaty between the United States and any other country regarding recognition and enforcement of judgments, the United States is a party to some multilateral treaties requiring the recognition and enforcement of arbitral awards. For this reason, it is generally advisable to include submission to arbitration provisions in Subscription Documents, Side Letters and Investor Letters, as applicable, in which Foreign Investors are a party.

To the extent that enforcement is sought in the Foreign Investor’s country of domicile, the law of such country will determine whether any judgment is enforceable. Most countries with developed legal systems do have laws that provide for the recognition of legitimate judgments issued abroad. If the amount of damages does not appear excessive, foreign countries will typically consider, among other matters, whether (i) the court had proper jurisdiction, (ii) the defendant was properly served or otherwise had sufficient notice, (iii) the proceedings were fraudulent or otherwise fundamentally unfair, and (iv) the judgment violates the public policy of such foreign country. As with most litigation involving foreign parties, local foreign counsel should be consulted as to the particular laws of the applicable country.

Conclusion

As fundraising challenges persist, Funds will continue to seek additional sources of capital, including Foreign Investor capital. As Lenders adapt to meet the changing needs of their clients, we expect to see the Capital Commitments of Foreign Investors being included in the Borrowing Bases of more Subscription Credit Facilities. Those Lenders that can quickly and effectively evaluate the creditworthiness of these investors will be well-positioned to receive additional opportunities from their Fund clients.

Endnotes

1 “Sovereign Immunity Analysis in Subscription Credit Facilities,” Mayer Brown Legal Update, November 27, 2012, on page 9.

As the subscription credit facility market matures,1 lenders seeking a competitive advantage are expanding their product offerings to private equity funds (a “Fund”) from traditional capital call facilities made to closed-end Funds to other financing products, including lines of credit to open-ended Funds, separate-account vehicles and net asset value facilities.2 Another emerging product gaining traction in the market with some Fund sponsors (a “Sponsor”) is a so-called management fee credit facility (a “Facility”). A Facility is a loan made by a bank or other financial institution (a “Lender”) to the general partner (the “General Partner”) of the Fund or a Sponsor-affiliated management company or investment advisor (collectively, the “Management Company”) of a Fund, and has a collateral package that is distinct from other types of security arrangements commonly associated with Fund Financings

The basic collateral package for a Facility consists of the General Partner’s or Management Company’s, as applicable, right to receive management fees (“Management Fees”) under the Fund’s limited partnership agreement (the “Partnership Agreement”) or other applicable management or investment advisory agreement (the “Management Agreement”), and rights related thereto, together with a pledge over the deposit account into which the Management Fees are paid (the “Collateral Account”). A control agreement among the General Partner or Management Company, the Lender and the depository bank would be needed to perfect the Lender’s security interest in the Collateral Account. Additionally, since the General Partner, the Management Company or another Sponsor-affiliated entity (a “Special Limited Partner”) generally has an equity investment in the Fund, the security for a Facility may also include a pledge by such entity or other Sponsor-affiliated investing entity’s right to receive distributions from the Fund and, in some instances, its limited partnership interest.

Background

In a typical Fund structure, the General Partner or the Management Company receives Management Fees as compensation for evaluating potential investment opportunities, providing investment advisory services and attending to the day-to-day activities of managing the Fund.3 The Management Fee also covers operating expenses (such as overhead, travel and other general administrative expenses) as well as salaries for the Management Company’s investment professionals and other employees. The Management Fee payable by an Investor is often determined by multiplying a percentage4 times such Investor’s capital commitment. In addition, some Management Fee structures include a component that is based on the Fund’s performance so as to provide additional incentive to the General Partner or the Management Company to maximize the Fund’s performance.

Facilities are becoming increasingly popular for a number of reasons. First, Sponsors may find a Facility attractive because it provides the Sponsor (or applicable affiliated entity) with immediate capital to smooth its cash flow and pay operating expenses in between the typically quarterly or semiannual payments of the Management Fees it receives. Second, post-economic downturn, Investors are increasingly interested in seeing Sponsors make larger investments in the Funds they manage to increase their “skin in the game” and further align the Sponsor’s and Investors’ interests in maximizing Fund performance. By leveraging the income stream from future expected Management Fees, a Facility may help enable a Sponsor or its Special Limited Partner to make a larger commitment to a Fund than it otherwise may be able to commit. Also, to the extent a Sponsor or its Special Limited Partner is an Investor in a Fund, a Facility may be drawn on short notice to permit the Sponsor or Special Limited Partner to honor a capital call prior to receipt of cash from the principals or employees that ultimately constitute the Sponsor or Special Limited Partner. From the Lender’s perspective, aside from earning revenue from the fees and interest income generated by a Facility, providing a Facility to a Fund is also a chance for the Lender to broaden its relationship with the Sponsor and develop a deeper understanding of the Sponsor’s business and its potential financing needs. This in turn may lead to opportunities for a Facility Lender to provide other products such as subscription credit facilities, net asset value facilities, portfolio-company level financings or perhaps even private wealth products to the Sponsor’s principals.

While there are many potential benefits to both a Sponsor and a Lender associated with a Facility, it is important to note that a Facility is best-suited for established Sponsors that have significant Fund management experience and a proven track record of receipt of the Management Fees, ideally from a diverse platform of Funds. Management experience and an uninterrupted history of receiving the Management Fees are important because the Lender is ultimately looking to the Management Fees as the source of repayment of the Facility in underwriting the risk associated with lending to a particular Sponsor.

Even though Management Fee performance history and management experience of a particular Sponsor may make it an ideal candidate for a Facility, as more fully described below, not all Funds will have Partnership Agreements, Management Agreements or Management Fee structures that are suitable for a Facility. Further, some Partnership Agreements limit the General Partner’s or Special Limited Partner’s right to pledge its equity interest in the Fund, although, a pledge of any distributions associated with such equity interest may be possible. Thus, the Partnership Agreement and/or Management Agreement must be carefully analyzed to confirm that the intended collateral can be granted to the Lender and the Lender will be able to adequately enforce its rights against the collateral.

Structure and Loan Documentation

Facilities are typically structured as revolving lines of credit to the General Partner or Management Company (depending on the Fund’s structure), secured by a pledge by the General Partner or the Management Company of its right to receive the Management Fees and the account into which such Management Fees are paid. If the Sponsor group has made an investment in the Fund through a Special Limited Partner or other affiliated entity, the collateral package may also include a pledge of the right to receive distributions from the Fund and the account into which such distributions are paid. If the Sponsor manages more than one Fund, the collateral package may include Management Fee streams from multiple Funds and the right to distributions from those Funds.

The basic loan closing documentation for a Facility will typically consist of (i) a credit agreement, (ii) a security agreement pursuant to which the General Partner or the Management Company assigns its rights under the Partnership Agreement or the Management Agreement, as applicable, to receive and enforce the payment of Management Fees and proceeds thereof, (iii) a pledge of the Collateral Account into which Management Fees are to be paid, (iv) a control agreement covering the Collateral Account to perfect the Lender’s security interest therein and permit the blocking of such account by the Lender, (v) a security agreement from the Special Limited Partner or other Sponsor-affiliated entity pledging its right to receive distributions from the Fund, if it is the part of the collateral package, together with a pledge of the deposit account into which such distributions are to be paid and a control agreement covering such account, (vi) Uniform Commercial Code financing statement(s) filed against the applicable pledging entities, and (vii) and customary opinion letters, certified constituent documentation of the Fund and pledging entities, evidence of authority and related diligence items.

In addition to the traditional collateral package, it is not uncommon for a Lender to receive a personal guarantee by one or more of the principals in the General Partner, the Management Company or Sponsor to support the Facility. The extent of such a guaranty is often negotiated, and it is not unusual for a principal’s guaranty to be limited to a capped amount based on its pro rata ownership percentage of the underlying Fund and the related outstanding balance of the Facility, as opposed to a more traditional unlimited (or joint and several) guaranty of the Facility. A guaranty may also be delivered by the Special Limited Partner, the General Partner or the Sponsor, depending on the structure of the Facility and the identity of the borrower under the Facility.

The terms of a Facility will typically include customary representations, warranties, affirmative and negative covenants and events of default that a Lender would expect to see in any secured financing, along with a few provisions that are tailored to address the unique features of a Facility’s collateral package. Such provisions may include a requirement that the General Partner or the Management Company receive a minimum amount of Management Fee income, or that the amount of Management Fees received does not fall below a certain specified percentage of the aggregate commitments of the Fund’s Investors. A Facility will normally include limitations on amending the Partnership Agreement or the Management Agreement, and prohibitions on terminating or waiving the General Partner or the Management Company’s right to receive payment of Management Fees. Additionally, so that the Lender can monitor the Fund’s overall performance (and have advance warning of potential performance issues that may give rise to a reduction in Management Fees or Investors balking at paying Management Fees), a Facility will usually require regular financial reporting and may also include a minimum net asset value test with respect to the Fund’s investments or a similar financial covenant with respect to the General Partner, Management Company or Special Limited Partner, as applicable, and its investment in the Fund. Some Facilities that include a pledge of distribution rights may contain a maximum loan-to-value or similar metric measured by looking at the Special Limited Partner’s pro rata share of the underlying portfolio investments in the Fund.

Partnership Agreement & Management Agreement Diligence

As part of due diligence for any Facility, a Lender must carefully review the Partnership Agreement and Management Agreement for any restrictions on the right of the General Partner or the Management Company to pledge its right to receive Management Fees or the Special Limited Partner’s ability to pledge its right to distributions. For example, a potentially problematic, though not uncommon, restriction is that the General Partner or Special Limited Partner cannot pledge its economic interest in the Fund, which would include its equity interest, without the consent of a certain percentage of the other Investors in the Fund. Some Partnership Agreements allow for such pledges without the consent of the other Investors while others do not. To the extent Investor consent is required, it may be an impediment to entering into a Facility.

In addition, the Partnership Agreement or the Management Agreement should be reviewed to determine how Management Fees are paid, and whether they may vary over time. For example, the Management Fee may decrease upon termination of the period in which the Fund is permitted to make new investments. It is important for the Lender to understand whether Management Fees are paid by the Investors directly to the General Partner or the Management Company, or if Management Fees flow through the Fund and/or the General Partner (or another affiliated entity) to the Management Company, as applicable, so that the relevant Fund-related entities are included within the scope of the collateral documents to minimize potential leakage, if necessary.

Some Partnership Agreements provide for Management Fee offsets, whereby receipt by the Sponsor, its principals, employees or other affiliates of advisory, break-up or other similar fees and income related to the investment activities of the Fund may reduce the amount of the Management Fee. The Partnership Agreement and the Management Agreement should be reviewed to determine if such offsets exist, and the Lender should consider whether the loan documentation should prohibit the General Partner or the Management Company from applying any discretionary offsets if possible. Alternatively, the Lender may consider requesting that any such advisory fees or other income or proceeds that may be offset against Management Fees be included as part of the collateral package in addition to Management Fees if the Fund’s documents permit it.

In underwriting a Facility, Lenders will want to keep in mind that while the Partnership Agreement and the Management Agreement will dictate whether a Facility is permissible and how and when Management Fees are to be paid, exogenous events may occur that could affect the payment of Management Fees. For example, in the late 2000s during the market downturn, Sponsors with troubled Funds in fact suspended or eliminated their Management Fees. Even though such activities would be prohibited by the loan documentation for a typical Facility, it is important for Lenders to consider the overall investment and economic environment in which a Fund operates, as market conditions may stress the underlying underwriting assumptions of a Facility.

Conclusion

While Management Fee Facilities have not been very common to date, they are becoming increasingly popular and offer an opportunity for a Lender to kick off or expand its relationship with a Fund Sponsor. With a careful review of the relevant operating and constituent documentation of a Fund, it may be possible to structure a Management Fee Facility to offer a seasoned Fund Sponsor increased liquidity while satisfying a Lender’s underwriting criteria. Please don’t hesitate to contact any of the authors with questions regarding these Facilities, including the various structures that can be implemented in connection with their establishment.

Endnotes

1 A subscription credit facility, also known as a capital call facility, is a loan made by a bank or other credit institution to a private equity fund, for which the collateral package is the unfunded commitments of the limited partners in the fund (the “Investors”) to make capital contributions when called by the fund’s general partner (as opposed to the underlying investment assets of the fund). For a more detailed description of the subscription credit facility market and features of the subscription credit facility product in general, please see Mayer Brown’s Fund Finance Markets Legal Update “Summer 2013 Market Review” on page 19.

2 For an in-depth analysis of certain alternative Fund financing products, please see Mayer Brown’s Fund Finance Market Legal Updates “Structuring a Subscription Credit Facility for Open-Ended Funds,” on page 31, “Separate Accounts vs. Commingled Funds: Similarities and Differences in the Context of Credit Facilities” on page 35 and “Net Asset Value Credit Facilities” on page 44.

3 Depending on the Fund’s structure, Management Fees may be paid by the Investors through the Fund or GP to the Management Company or directly to the Management Company.

4 Historically, the percentage has usually ranged from 1.5% to 2% per annum.

Capital call subscription credit facilities (each, a “Facility”) continued their positive momentum in 2013 and had an excellent year as an asset class. As in the recent past, investor (“Investor”) funding performance remained as pristine as ever, and the only exclusion events we are aware of involved funding delinquencies by noninstitutional Investors (in many cases subsequently cured). Correspondingly, we were not consulted on a single Facility payment event of default in 2013. In addition to the very positive credit performance, the asset class seemed to enjoy significant year-over-year growth. Below we set forth our views on the state of the Facility market and the current trends likely to be relevant in 2014

Material Growth and Its Drivers

While the Facility market currently lacks an industryaccepted data collecting and reporting resource making it difficult to pinpoint the exact size of the market, we are confident based on our experiences as well as anecdotal reports from multiple Facility lenders (each, a “Lender”) that the Facility market expanded materially in 2013. As one available data point, the Mayer Brown LLP Facility practice was up 66% in 2013 compared to 2012, measured by volume of consummated transactions. This positive growth for Facilities in 2013 was driven by a confluence of factors, not the least of which was the uptick in the fund formation market (especially in the United States). According to Preqin data for the U.S.-based fund market, 485 closed-end real estate, infrastructure and private equity funds (each, a “Fund”) raised an estimated $261 billion in gross capital commitments in 2013, which represents the highest levels seen in the market since 2008. This baseline growth in the number of prospective Fund borrowers clearly seeded the Facility market’s growth, but other factors contributed extensively as well. We believe the Facility market would have expanded in 2013 even had the Fund formation market remained stagnant, as penetration into Funds that have historically not availed themselves of Facilities increased. Growth in 2013 was also supplemented by an increased recognition by Lenders of the quality of Facility collateral and, in reliance on that collateral quality, a greater comfort with customized Facility structures. Lenders clearly consummated Facilities in 2013, and included Investor capital commitments (“Capital Commitments”) in borrowing bases, that would not have satisfied underwriting requirements previously. Similarly, Funds extended many of their existing Facilities upon their maturity instead of calling capital and paying them off, in many cases even well after the termination of their investment periods. This continuity of use of Facilities throughout a Fund’s life cycle clearly contributed to 2013 growth as well.

Challenges

2013 was not all roses and champagne for the Facility market however, as certain very real challenges emerged. Fund formation was not up uniformly across the globe; Europe and Asia still report very challenging fundraising environments for Funds, especially for relatively new fund sponsors (each, a “Sponsor”). These challenges resulted in the deferral and in some cases impracticability of potential Facilities. For Lenders, spread tightening had a very real impact on internal returns, as virtually every amend and extend consummated in 2013 priced flat to down from its precedent. And Facility structures trending downward on the credit spectrum created challenges for virtually every Lender in terms of internal credit approvals and policy adjustments. But on the whole and despite these challenges, 2013 was a very positive year for the Facility market.

Key Trends

In our Summer 2013 Market Review, we identified four key trends that were impacting the Facility market: (i) the general maturation of the Facility product and market; (ii) the continuing expansion of Facilities from their real estate Fund roots into other Fund asset classes, and particularly, private equity; (iii) Fund structural evolution, largely responsive to the challenging fundraising environment and Investor demands; and (iv) an entrepreneurial approach among Funds to identify new Investor bases and new sources of Capital Commitments.1 We think these trends hold.

They bear repeating here because they will continue to have a material impact on the Facility market in 2014 and beyond.

But there are a number of additional trends that either presented or accelerated in the second half of 2013 that we believe will become increasingly relevant in the Facility market in the year ahead, including the following: (i) an improving global fund formation market, which will drive Facility growth in 2014, especially in international sub-markets; (ii) an influx of new market participants in particular Facility sub-markets, bringing different structuring standards and mixing up existing competitive balances; (iii) an expansion of Investor interest in Facilities, including the exercise of influence into Facility terms and structure; (iv) Lender recognition of the positive historical credit performance of Facilities and a resulting comfort in expanding traditional frameworks and going further down the credit spectrum; (v) a constantly evolving regulatory environment for Lenders coupled with real difficulty applying promulgated regulation to Facilities; and (vi) continuing stress on some of the largest Investors—municipal pension funds—and accelerating interest in procuring defined contribution plan monies for Funds. We analyze each below.

An Improving Global Fund Formation Market

We are seeing increased Fund formation activity globally, including in Europe and Asia which have been somewhat slower to emerge from the crisis. Based on 4th Quarter 2013 experiences and certain recent macroeconomic data, we are optimistic this positive trend will continue into 2014. According to Preqin data, non-North American based and focused Funds raised approximately $144.4 billion in capital in 2013, up slightly from 2012. Additionally, according to Preqin surveys, 34% of all expected Fund launches in the market are targeted with a geographic focus in Asia. Thus, our expectation is that a moderate to healthy increase in consummated Funds will lead to additional expansion of the Facility market in 2014, perhaps with the biggest growth occurring outside of the United States.

New Market Participants

The Facility market has for some time noted the efforts of new entrants (Lenders, law firms, etc.) trying to establish themselves in the space, each with different strategies and often with varying levels of success. In 2013 however, certain new entrant movements occurred or accelerated that have the potential to be disruptive to the historical competitive dynamics, at least at the margins. For example, multiple European Lenders are investing in and building their capabilities in the United States. Unlike some of their new entrant predecessors, these Lenders have real, demonstrable execution capabilities, if primarily in a different sub-market. Similarly and in reverse, many of the dominant US Lenders are increasingly attentive to Europe and Asia, recognizing the positive opportunities those sub-markets may hold. Several US-based Lenders had demonstrable success in 2013, at least in Europe. As Lenders emigrate in both directions, they bring their historical Facility structures and underwriting guidelines to the new sub-market. As a result, Funds are increasingly finding themselves with term sheets for Facilities that are no longer distinguishable only by Lender name and pricing. Funds are now weighing significant structural variation (a traditional borrowing base vs. a coverage ratio, as a simple example) in their Facility proposals.

Along a parallel path, multiple regional US Lenders are expanding beyond their historical geographies and middle-market Fund roots, often in efforts to keep up with the growth of their Fund clients. Many of such regional Lenders have increased their Facility maximum hold positions to levels comparable to that offered by the money center Lenders, at least for certain preferred Funds. In fact, several of the regional Lenders made substantial progress increasing their relevance in the greater Facility market in 2013. As their Facility structures and underwriting parameters often differ from a traditional Facility, they are also altering the competitive landscape. Correspondingly, variances in Facility structure dictate the syndication strategy and prospects for a particular Facility, adding additional complexity to a transaction.

Expansion of Investor Influence Into Facilities

Investor recognition and consideration of Facilities is increasing, and Investors are taking a more active look at how Facilities are structured and what their delivery obligations are in connection with a Facility. Investor side letters (“Side Letters”) now routinely incorporate provisions addressing the Facility, often displaying Investor efforts to carve back their delivery obligations to Lenders. We often see entire Side Letter sets with a limitation that Investors only need deliver financial statements made publicly available. Further, a few tax-exempt Investors have inserted themselves into Facility structuring, insisting that the parallel fund they invest through be only severally liable for borrowings under the Facility so as to preserve a more favorable tax structuring analysis with respect to the separation between the multiple parallel funds. Whether facilitated through the work of the Institutional Limited Partners Association or just via greater investing experience, Investors appear increasingly aware of the Facilities their Funds are entering.

Extension of Credit Guidelines

No doubt partly in response to both the excellent historical credit performance of Facilities and the competitive landscape, Lenders are increasingly willing to go further down the risk continuum than they have in the recent past. While this has been true for some time now with respect to the historical requirements for delivery from Investors of acknowledgment letters (“Investor Letters”) and legal opinions, we are now seeing a greater acceptance of less than ideal Fund partnership agreements (“Partnership Agreements”). Many Lenders are no longer requiring a near-verbatim recital of a historical form Investor Letter in the Partnership Agreement, but instead are accepting less explicit authorization and acknowledgment language. Similarly, Lenders are increasingly finding ways to get comfortable including municipalities with sovereign immunity issues, certain sovereign wealth funds and fund of funds in a borrowing base that have historically been excluded. We have also seen some shifting in view on Investor withdraw/ cease funding rights in relation to a Fund’s breach of its representations regarding placement agents and political contributions, with some Lenders now willing to partially accept this risk, at least in limited concentration scenarios. Further, we have seen a relatively significant expansion in the underwriting consideration of Fund assets, both in terms of supporting more aggressive borrowing bases and for mitigating other perceived credit weaknesses in a particular Facility, such as a tight overcall limitation. Notably, many Lenders are now actively considering NAVbased facilities or hybrid variations (especially for Funds later in the life cycle), and we expect these trends to continue as Lenders look for higher yielding opportunities.

Importantly, in our view, we think the data supports these trends. We see this as a rational expansion based on the greater availability of positive historical Investor funding and Facility performance data; we have not yet seen many Facilities consummated which we deemed unduly risky or reaching.

The Regulatory Environment

Lenders are, and have been since the crisis, facing a regulatory environment as challenging as we have seen in a generation. Many of the regulations emanating from the crisis are now moving to the finalization and implementation stages, and Lenders are having to adapt.

Moreover, additional regulations continue to be proposed. Virtually every post-crisis law and regulation that has been proposed or implemented is not express as to Facilities, and judgment must be applied to determine the appropriate impact. For example, the Volcker Rule’s application to Facilities, whether a Facility constitutes a “securitization” under the European securitization risk retention regulation CRD 122a and what outflow rate is appropriate under the recently proposed US Liquidity Coverage Ratio requirements are all occupying significant time at present.2 We think it is quite possible some of these regulations will lead Lenders to offer structural variations to their Facilities, such as uncommitted Facilities or uncommitted Tranches within Facilities, as a means of counteracting some of the regulatory capital burdens accompanying changing regulation. We expect the regulatory environment will be increasingly relevant in 2014, as Lenders adapt to the shifting landscape.

Municipal Pensions

Municipal pension funds (“Municipal Pensions”) in the United States, often the flagship Investors in Facilities, are under ever-increasing economic pressures. Despite the relatively robust performance of the equity markets in the United States and the significant rebound in many real estate markets in 2013, the outlook for Municipal Pensions to meet their prospective funding obligations seemed to get bleaker on a real-time basis last year. Many states are actively making efforts to enact reform, but such reforms are severely limited by constitutional protections for earned and accrued benefits, let alone political gridlock. The initial holding by the U.S. Bankruptcy Court for the Eastern District of Michigan that Detroit has the ability to alter its pension obligations under Chapter 9 of the U.S. Bankruptcy Code combined with Illinois’ massive funding deficiencies and reform struggles have furthered the uncertainty.3 We expect Municipal Pensions to occupy the headlines throughout 2014 and for a considerable period of time to come. We think these funding deficiency challenges are ultimately (although not promptly or easily) solvable, and we expect a major part of any solution will include a greater emphasis on defined contribution plans (“DC Plans”) for employees going forward. As a result, our expectation is that the credit profile of many Municipal Pensions will continue to trend negatively in 2014 and that Sponsors will be increasing their speed of pursuit of a Fund product for DC Plans. We forecast breakthroughs in this regard in 2014 and think Facility market participants should all be thinking about how the connection between DC Plans and Funds could best be structured to positively impact the Facility market.

Additional Trends

In the coming years, we also expect to see healthy growth in the volume and frequency of commitments to Funds by sovereign wealth funds and in the use of separate accounts by Investors.4 Preqin estimates show that in 2013 sovereign wealth funds surpassed the $5 trillion mark for total assets under management, a number which is up more than $750 billion from 2012 and nearly $2.5 trillion since 2008. Meanwhile, 19% of Investors surveyed by Preqin currently invest through separate accounts, as opposed to only 7% a year ago. 64% of those surveyed indicated that separate account commitments will become a permanent part of their investing strategy going forward. Thus, including sovereign wealth funds in Facility borrowing bases and single Investor exposure when lending to separate accounts will become increasingly relevant for Lenders going forward.

Conclusion

We project a robust Facility market in 2014 building on the growth and positive momentum experienced in 2013, but with challenges at the margins. We expect the number of Facilities consummated will continue to grow at a solid clip as fundraising improves, the product further penetrates the private equity asset class and a greater number of existing Facilities get refinanced. But we expect that Fund structural evolution, Investor demands and competitive dynamics will continue to challenge Facility structures and ultimately drive Facilities somewhat further down the credit continuum.

Endnotes

1 Summer 2013 Market Review, please refer to page 19.

2 For an in-depth review of applying the Liquidity Coverage Ratio to Facilities, please see Mayer Brown’s Legal Update, Capital Commitment Subscription Facilities and the Proposed Liquidity Coverage Ratio, on page 75.

3 For more information about the initial holdings in the Detroit, Michigan bankruptcy proceeding, see Mayer Brown’s Legal Update, Detroit, Michigan, Eligible to File Chapter 9 Bankruptcy, on page 127.

4 For more information regarding separate accounts, please see Mayer Brown’s article, Separate Accounts vs. Commingled Funds: Similarities and Differences in the Context of Credit Facilities, on page 35.